So what would a credit downgrade mean?

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Recently a chorus of ratings agencies has warned that if the U.S. doesn’t reach an agreement on the debt ceiling and budget deficit, they could downgrade the U.S. from the top rating, triple-A. This has put added pressure on lawmakers to hammer out a deal in a timely manner – something they haven’t even been close to accomplishing.

Standard & Poor’s (S&P) ratings agency recently said there is a 50/50 chance the nation’s credit rating will be downgraded. More important (and concerning), S&P is now saying that as a result of the U.S.’s underlying fiscal problems, the U.S. could be downgraded even if the debt ceiling was raised by the August 2nd deadline.

Senior federal officials have been perplexed (to put it mildly) by S&P’s approach which seemed to conflict with the agency’s pervious stance that a debt ceiling increase would be sufficient in the short-term with the assumption of a larger budget fix in the next two years.

Beers told M.M.: “What we are focused on is not the debt ceiling but the underlying state of public finances … There is a rising trajectory of [debt] that left unchecked would be incompatible with a triple-A rating. … And it is less certain now than it was back in April that whatever deal might emerge from this is going to be of sufficient scope that it is going to make a big dent in the debt trajectory. … “[In order to maintain a triple-A rating] what would have to emerge would be something that has a material impact on the underlying fiscal issues. …

Today, Third Way released a document by policy advisors David Hollingsworth and Lauren Oppenheimer with an explanation of how a downgrade would occur and what it would mean for the country. In the report, Third Way echoes S&P’s explanation that a downgrade doesn’t hinge exclusively on raising the debt limit. “Trepidation over whether the United States will increase the debt limit is not the only driver of rating agencies’ concerns about the safety of America’s debt,” write Hollingsworth and Oppenheimer. The authors explain that there are a series of requirements for the U.S. to stave off a downgrade. “While raising the debt ceiling to avoid a government default is one of those actions – it is only one of those actions. All three major credit ratings agencies would keep a “negative outlook” on the United States AAA rating without a credible medium term plan in place to stabilize the debt trajectory.”

So what does this all mean? The Third Way report looks ahead to what a downgrade could mean for the economy:

Losing one’s AAA status is often not a short term occurrence. When Canada was downgraded in 1993, it took 9 years to recover. Japan was downgraded from AAA in 1998 and has not recovered. Spain was downgraded in 2009 and has yet to recover.

The result of a downgrade is that issuing debt generally becomes more expensive. It is unclear just how much more expensive it would be for the United States. The investment firm AllianceBernstein…says, “the longer term question is whether the market will decide that the U.S. is simply incapable of addressing its underlying structural issues with Social Security, Medicare and other entitlement programs.”

[A] downgrade would have a severe impact on U.S. financial markets. For example, a downgrade on U.S. Treasuries would result in a downgrade of some U.S. states as well as Fannie Mae, Freddie Mac, Federal Home Loan Banks and the Federal Farm Credit System. In fact, some worry the repercussions are already being felt. According to Mark Zandi, Chief Economist at Moody’s Analytics, “Our aura is diminished. You know people really view the U.S. as the AAA, the gold standard, and I think we’re tarnishing that.”